Week ended March 18th 2022
There were no massive surprises this past week as the Fed and BoE did just as expected, and the war in Ukraine unfortunately ground on with no resolution in sight. Markets continued to be choppy but directionally settled down in the latter half of the week, with prices of risk assets – especially equities – soaring the final two trading sessions of the week whilst US Treasuries resumed their price declines. Similar to USTs, other “risk-off” assets – gold, the US dollar and the Yen – sold off as investors rediscovered their mojo. Oil prices also fell sharply in the early part of the week but came off their mid-week lows as the week wore on. Perhaps investors realised that supply interruptions emanating from sanctions on Russia will worsen before they improve, so we must get accustomed to the current demand-supply imbalance for global oil. Corporate credit also stabilised with spreads tighter across the board (as underlying UST yields increased), even as corporate bond yields rose for investment grade (BBB) bonds and were (only) slightly improved for high yield bonds.
[If you want to go straight to the tables, click this link.] Stateside, the Fed raised the federal funds rate 25bps just as expected on Wednesday (FOMC statement here), with the equity and bond markets reacting erratically in the moments following the release and during Chairman Powell’s press conference, but then rallying into the session end. Investors were focused on the so-called dot plot, suggesting a more aggressive series of Fed Fund rate increases ahead, as well as on the upward revisions to inflation and the downward revisions to growth. For example, in December – only three months ago – the Fed projected GDP growth and PCE (personal consumption expenditures, a proxy for inflation) for 2022 of 4.0% and 2.6%, respectively. However, the Summary of Economic Projections just released by the Fed (here) revised US GDP growth down to 2.8% (from 4.0%) and PCE up to 4.3% (from 2.6%) for 2022. Interestingly, the Fed expected that the increase in Fed Funds rate for 2022 would be 0.25% to 1.00% (one to four increases of 25bps) at the December meeting, but this range was revised significantly upwards by the March FOMC meeting to 1.50% to 3.25%. Stocks absorbed this news by rallying, whilst US Treasury bonds got hammered as yields headed higher. The yield curve also flattened further, signalling a growing conviction that US economic growth will slow in the coming quarters. More concerning, a recession might be on the horizon if the Fed’s aggressive tightening to address inflation overshoots.
In the UK, the Bank of England raised its overnight Bank Rate on Thursday at its third consecutive Monetary Policy Meeting. The increase was 25bps, bringing the Bank Rate to 0.75% (vs the current Fed Funds rate of 0.25% - 0.50%). Similar to Fed economic revisions for the US, the BoE is also projecting slower growth and higher inflation in the UK, saying in fact that inflation could reach 8.0% or more by April. You can find the BoE Monetary Policy Statement for March here. Reading through the policy statement you will see many more references (than in the FOMC minutes) to the (negative) effects of Russia’s invasion of Ukraine on the UK economy. Similar to the Fed, the BoE will have plenty of challenges navigating a soft landing. Both the US and UK economies are slowing, increasing the risk that they might at some point face a wicked combination of rising inflation and simultaneous increasing unemployment (i.e. “stagflation”), a most undesirable economic dilemma. The ongoing atrocities in Ukraine by Russia also continued, with glimmers of hope from time to time that the sides might be moving closer to an agreement. Each time these rumours surfaced, the optimism was quickly quelled. It is difficult to have much confidence in these periodic proclamations when time and time again, they emerge without substance. What is clear is that Ukraine is being destroyed and the Russian economy is on its knees. Interestingly, it appears that Russia made two interest payments (in US dollars) on Eurobonds, although it seems bondholders are only gradually receiving payments from the paying agent. The economic deterioration in Russia is the price that Mr Putin has obviously decided he is willing to pay to bring Ukraine under Russian influence. It’s hard to tell how this will end or how long it will drag on, but clearly it affects risk sentiment and – most notably – the price of oil, nickel and select other commodities. I consider this risk to remain skewed towards the downside in the near-term given the wide range of potential outcomes, although investors clearly believed otherwise based on the end-of-week rally.
One more footnote to the weekly update is that a new variant of COVID – the BA.2 Omicron variant (more contagious but apparently less dangerous than Delta) – is rapidly spreading in the UK. This is not particularly problematic for those that have been vaccinated or have had COVID, but many countries (and US states) with low vaccination rates might be more vulnerable as the new variant spreads. Hong Kong is also in the midst of a severe and widespread COVID outbreak. China will also be interesting to monitor since the country’s response to COVID – relying on harsh and immediate lock-downs of COVID hotspots – has been different than the responses of most other countries. Otherwise, economic activity is continuing to normalise as people return to their pre-pandemic routines.
Global equities rallied across the board this week, largely ignoring the combination of central bank hawkishness to address ever-increasing inflation, sharp increases in yields, and on-going uncertainties around the war in Ukraine. Aside from Chinese equities, which remain under severe pressure, all of the other equity markets I track rallied strongly. The Nikkei 225 was the best performer for the week. The only index positive YtD is the FTSE 100, with the other global indices I track in the red YtD, down between 6.4% (S&P 500/US) and 10.7% (SSE Comp/China).
US equities rallied sharply during the week, with the NASDAQ Composite – the worst performing US index YtD – being the best performer, up a sizzling 8.2% for the week. As you might expect, technology shares were the drivers of this performance as investors decided that some of these names – even the “large tech” bellwether stocks – had been overly battered since the beginning of the year. The rally gained steam across all indices as the session neared its close on Friday, indicating that investors were not selling into strength but were instead adding to their positions. Are we back to a “buy the dip” mindset? We will find out in the coming weeks.
US Treasuries / government bonds
US Treasuries sold off sharply as the final reminents of support from investors seeking safe haven protection from volatile markets faded. The most severe damage was at the short end of the yield curve. The yield on the 2y UST rose a stunning 22bps WoW, even touching 2% intraday on Wednesday. The Fed’s FOMC minutes and press conference mid-week accelerated the sell-off, as the Fed re-affirmed its hawkish approach although continuing to stress that its policy direction is data-dependent. The economic forecasts released simultaneously by the Fed suggested that there could be rate rises at every upcoming FOMC meeting this year, perhaps some for 50bps (as opposed to just 25bps). I believe that based on the substantial difference between the 2y US government bond yield (1.97%) and the Fed Funds rate (0.25%–0.50%), it is clear that the Fed is well-behind where it should be in this tightening cycle, especially when comparing the interest rate difference between 2y government bonds and overnight bank rates in both the UK and Eurozone, which are in both cases less than 75bps. The bond market is clearly ahead of the Fed, as it has been now for many months.
Safe haven / other assets
As mentioned in the opening sections of this update, the US Treasury market wasn’t the only market to face the brunt of investors abandoning risk off assets / currencies and heading back to the equity casino. Gold, the US dollar and Yen – traditional safe-haven assets – also lost ground last week.
The question perhaps is have we now seen the peak of US dollar strength? I doubt it for reasons I alluded to earlier, mainly because the Ukraine-Russia conflict has such an uncertain outcome. I discussed oil earlier, too, which was down for the first week in many, although it did come off its mid-week lows as investors came to their senses regarding the gravity of global oil supply problems. Bitcoin staged a nice rally this past week, mimicking US equities and – as usual – showing that the benchmark cryptocurrency both has strong support at levels in the mid/high $30,000s and very much behaves like a risk-on asset.
Corporate credit (i.e. corporate bonds)
In corporate credit, it is customary for corporate credit yields to lag changes in underlying government bond (risk-free) yields, meaning that as yields on government bonds increase, yields on corporate bonds increase more slowly. This normally results in a transitory period of spread tightening until a “catch up” can be achieved. We saw this in action this week. If you focus on the table with credit yields, the yield on the BBB-rated corporate bond index increased (meaning bond prices fell), but the BBB-index yield increased less than UST yields. This caused the credit spread on the BBB-index to tighten (from 1.82% to 1.71%) during the week even as yields were rising. Both USD- and EUR-denominated high yield bonds experienced slightly lower yields during the week though, since their spreads compressed (i.e. improved) more than underlying UST yields increased. High yield bonds also tend to be a beneficiary of risk-on sentiment. As I have mentioned on numerous occasions, I consider USTs and investment grade corporate bonds both to remain at severe ongoing risk of rising yields. High yield bonds have more cushion to absorb steadily increasing UST yields but will still be affected. The intermediate-term risk for high yield is different and involves an adverse change in investors’ perceptions regarding performance and potential defaults, a concern that – as of yet – has not been visible either in the data tracking such defaults or in investor sentiment. However, investment grade corporate bond yields – more reliant on the yield in underlying government bonds as the benchmark – actually increased too, even though the credit spread was sharply.